This is a big step for China’s markets. But investors won’t care

August 18, 2016 | Kim Iskyan

It’s about to become a lot easier for foreign investors to invest in the second-busiest stock market in the world. That doesn’t mean they will. But other Chinese shares listed elsewhere are a better buy.

China’s Prime Minister Li Keqiang yesterday announced that in December, a trading link between the Hong Kong and Shenzhen stock exchanges will be launched. That means that international investors will be able to buy shares traded on the Shenzhen exchange – which is the second most-important stock market in China – without having to individually get prior government approval.

The trading link mirrors the Shanghai-Hong Kong Stock Connect, which began in November 2014 and made it far easier for foreigners to buy Shanghai-listed securities.

The Shanghai-Hong Kong aftermath

The launch of the Shanghai-Hong Kong link coincided with the beginning of a bubble in Shanghai-listed stocks. In the seven months following the Shanghai-Hong Kong Stock Connect, the Shanghai Stock Exchange rose 109 percent.

But what played a bigger role in the bubble than foreign capital were lower margin lending rates for local Chinese investors, and an active campaign by the Chinese government to promote share investment.

That bubble ended in tears, with the Shanghai Composite dropping 49 percent from its 2015 high to its 2016 low. It’s still 40 percent below its 2015 highs.

Shenzhen-listed stocks are too expensive

There probably won’t be a similar bubble with the launch of the Shenzhen Connect. First, caution – rather than cowboy – is the main attitude in Chinese markets today. The ham-fisted way the Chinese government handled the collapse of the bubble last summer scared a lot of investors. Market regulators showed that they were still stuck in an ancient communist mindset – rather than one where investors can vote with their feet in seconds.

But the real issue is that shares listed in Shenzhen are expensive, trading at an average price-to-earnings (P/E) ratio of 46. That means that for every yuan of company earnings, investors are paying 46 yuan. That compares to the Hang Seng’s average P/E of 12 and the Shanghai Composite’s 17. (By comparison, Singapore’s STI has a P/E of 12 and the S&P 500’s P/E is 20.) The high valuations of the overall Shenzhen market will limit investor interest.

The real impact of the Shenzhen-Hong Kong Connect

When announcing the Shenzhen-Hong Kong Stock Connect, Prime Minister Li said the link was “a substantial step forward in terms of legalisation, marketisation and internationalisation” of China’s capital markets.

This liberalisation is another step to mainland China shares being included in big emerging market indices, like the MSCI Emerging Markets index. As we’ve written before, this index is tracked by funds that manage US$1.5 trillion in assets. If mainland-listed shares, called China A-shares, are added to the index it would mean billions of dollars in new A-share purchases over time.

This one change to one index would have a major impact on China A-share prices. And if MSCI eventually adds them to its suite of indexes, other index providers will likely do the same.

In June, MSCI announced that it would not add A-shares to the index and would instead take a “wait-and-see” approach to the mainland China market. The Shenzhen-Hong Kong announcement signals that China is continuing the process of liberalising its stocks markets. However, the real evidence of this will be how regulators respond the next time they’re faced with plummeting shares, like last summer and in January.

The best way to invest in Chinese shares

There’s a better way for foreigners to invest in mainland China companies, at cheaper valuations.
We’ve written about China H-shares before. H-shares (not to be confused with the previously mentioned A-shares) are the Hong Kong-listed shares of Chinese companies. They’re governed by Chinese law but denominated in Hong Kong dollars. They’re one of the easiest ways for foreign investors to buy shares in mainland China companies, and they trade at a P/E of just under 8 (based on the HSCEI index that tracks H-share prices). That makes this one of the cheapest stock markets in the world.

You can invest in H-shares using ETFs. The Lyxxor China Enterprise (HSCEI) UCITS ETF is available to Singapore investors (code: P58); Hong Kong investors can trade the HSCEI index using the Hang Seng H-Share Index fund (code: 2828); and if you can trade on the New York Stock Exchange, try the iShares China Large-Cap Fund (ticker: FXI).

Kim Iskyan

About Kim Iskyan

Kim Iskyan has nearly 25 years of experience as a stock analyst, hedge fund manager, political risk consultant, and financial commentator in more than half a dozen emerging and frontier markets.

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